Careful with that ETF says Watson Wyatt

The exchange traded fund industry has been feted as offering low cost access to a wide range of investment opportunities. It has occasionally had its knuckles rapped for getting over-enthusiastic about short and leveraged products that may not track in the way investors expect. But generally, the plain vanilla FTSE 100 or S&P 500 ETFs have been seen as A GOOD THING.

Now along comes Watson Wyatt to throw a bucket of cold water on the ETF party. The consultant says institutional investors can get a better deal elsewhere. There are institutional index products with lower fees, a better tax structure, and less or no counterparty risk.

Watson commends ETF providers for their innovation but says it is waiting for more competitive fees and transparent structures before it can advise investors to make use of them for long-term investment purposes. It also accuses the industry of product proliferation rather than “genuine innovation in the investment content of index products”.

Anyone who has struggled to make use of ETFs must agree with this assessment. There are loads of ETFs with similar names that probably do similar things. Finding out what are the differences between them takes time.

There is “a lot of noise” around the profusion of ETFs on the market, according to Watson Wyatt.

The real story is investors’ realisation that capitalisation-weighted portfolios are not necessarily optimal, leading them to contemplate shifting significant assets into alternative weighting approaches.

This is one of the consultant’s pet projects, but it hasn’t taken root in the ETF industry. In fact, some of the fundamental indexed ETFs have closed for want of interest and assets. There clearly isn’t much demand for this approach among ETF investors.

On the costs front, another communication this week, from Evercore Pan Asset, a wealth manager, suggests ETFs are cheaper than they look if you judge just by the total expense ratio. Their securities lending activities can offset the annual charge and cut costs to very little. Evercore Pan Asset says tracking error is a better indicator of cost.

Watson, though, is not keen on the counterparty risk associated with securities lending. It says:

It is not clear that investors are being adequately compensated for having to take these risks when holding an ETF.

By chance, the Watson diatribe was followed shortly in my inbox by an announcement that Barclays Capital is launching its first iPath exchange traded note in Europe. Just what we need isn’t it – yet another product with counterparty risk offering access to some exotic instrument, in this case the Vix.

Interesting to note that, having sold off iShares, Barclays hasn’t waited long to rejoin the ETF party through its investment banking arm. What does that tell us about the ETF market? There is plenty of profit opportunity for hungry investment banks.

We need someone to come up with a really simple, cheap and straightforward product. Any ideas?

About the blog

FTfm is no longer updated but it remains open as an archive.

FTfm's specialist writing team offer their insights into the global fund management industry.

About the authors

Pauline Skypala has been editor of FTfm for four years having previously been deputy personal finance editor. She joined the FT in 1999 and has been writing on savings and investment issues throughout her career.

Steve Johnson, FTfm deputy editor, has been a journalist for 17 years, 10 of which have been with the FT.

Sophia Grene, reporter on FTfm, has been a financial journalist in print and online for 12 years.

Ruth Sullivan has worked as a financial/business journalist and foreign correspondent and for the past 10 years has been at the FT.